A recurring problem I have is explaining to retail that liquidity is a Thing, and further that it’s a Thing that affects all markets, including government bonds and explains much of the spread between corporate and government bonds.
I am told quite often that liquidity is not a Thing in government bond markets because my interlocuter has never had any problems getting his $25,000 orders filled.
So I was pleased to see Staff Analytical Note 2023-11 published by the Bank of Canada, written by Jabir Sandhu and Rishi Vala, titled Do hedge funds support liquidity in the Government of Canada bond market? – the best part was:
Two-sided markets can help dealers more easily fulfill the transactions of their different clients, potentially supporting market liquidity. To assess whether the transactions of hedge funds promote two-sided markets, we estimate the extent to which hedge funds trade GoC bonds in the opposite direction to other clients. Our measure of opposite direction transactions is the ratio of hedge funds’ net daily transaction volume for each GoC bond relative to that of other clients. We calculate the average of this ratio across bonds on each day. We exclude the period between March 9 and 20, 2020, to get a better idea of the typical behaviour of hedge funds. Our measure does not consider whether hedge funds initiate a transaction. It is plausible that hedge funds demand liquidity while they transact in the opposite direction of other clients. Nevertheless, our measure is useful for assessing hedge funds’ contributions to two-sided markets.
Chart 2 shows the median of the opposite direction ratio over our sample period for hedge funds and for other types of clients. Hedge funds have a median ratio of around -14%, which means that hedge funds typically trade 14% of the volume of GoC bonds transacted by other clients, but in the opposite direction to other clients. Another interpretation is that, all else being equal, without hedge funds, dealers would have to intermediate an additional 14% of transaction volume from other clients, using their own balance sheets. Most other types of clients’ transactions are typically either not in the opposite direction or have smaller opposite direction ratios.
I remember being told by the chief bond trader at a major bank that my old firm was very helpful to him in the course of day to day operations, because our trading was generally counter-flow, helping him to turn over his inventory a little more quickly (it also reduces the need for hedging). Naturally, a discount has to be applied to what a dealer says because half their job is to tell clients how smart they are, but the words made sense at the time and make sense now.
Another gem is:
We follow the methodology of Czech et al. (2021) to construct a GoC bond portfolio based on the bonds that hedge funds bought and sold the most on each day they transact in the opposite direction of other clients. We then calculate the excess returns of each day’s portfolio over different horizons (see the Appendix for details). This approach is only a proxy to assess hedge funds’ excess returns because their strategies may involve assets other than GoC bonds. Nevertheless, the approach is useful to assess whether hedge funds are capitalizing on imbalances in the GoC bond market.
Chart 3 shows the excess returns from hedge funds’ GoC bond transactions over a 1-, 5- and 10-day horizon. These excess returns are statistically significant and increase up to the 5-day horizon but lose significance and return close to zero at the 10-day horizon. These results suggest that on days when hedge funds transact in the opposite direction, they could be capitalizing on temporary supply and demand imbalances because their transactions generate excess returns over a short horizon and then decline toward zero.
This ties in with my essay titled ‘Naive Hedge Funds’.
At my old firm, our holding period was much longer than the very short intervals studied in this chart, but that is because we weren’t, technically, a hedge fund (except for a little bit with a specialty product); we were investment managers, seeking to hold the cheapest portfolio of cash-flows that we could, subject to various constraints on portfolio composition that essentially made us more of an ‘index-plus’ firm rather than a classical hedge fund.
The authors conclude:
While GoC bond transactions of hedge funds are typically in the opposite direction to those of other market participants, we find that during the peak period of market turmoil in March 2020, hedge funds sold GoC bonds, just as other market participants did. This shows that hedge funds can at times contribute to one-sided markets and amplify declines in market liquidity. These results help to advance Bank staff’s understanding of the asset management sector and of asset managers’ behaviour in periods of market turmoil.